16 December 2010

Citi: SKS Microfinance- Downgrade to Sell: More Pain Likely, and Field Trip Takeaways

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SKS Microfinance (SKSM.BO)
 Downgrade to Sell: More Pain Likely, and Field Trip Takeaways

 Downgrade from Hold to Sell — We downgrade SKS from a Hold to Sell (3M)
with a Rs605 TP despite a sharp stock correction. The current regulatory imbroglio
has unraveled more sharply than expected and will likely leave a trail of impact on
earnings, growth and asset quality even if resolved quickly. If it prolongs, the
impact could be higher, with possibilities of further downsides to the stock. We are
cutting earnings 41-52% over FY11-13E to factor in reduced lending rates, higher
funding costs, lower growth and increasing credit cost requirements medium term.

 Impact of new AP Regulations — The Microfinance Bill has recently been
passed in the AP Assembly and, if enacted, could impact: a) NIMs – SKS has
reduced its effective lending rate by around 2% and funding costs are also likely to
go up as banks get increasingly risk averse; b) Loan growth – Incremental
disbursements have still not resumed in AP and slowed down elsewhere; c) Asset
quality – even a quick resolution will likely result in 10-20% NPLs in AP (25% of
book) and more in case of delays; there is no contagion yet, but stoppage of
incremental credit can lead to higher NPLs elsewhere as well; and d) Access to
funding – Banks are increasingly becoming risk averse, suggesting funding will be
tighter and costlier, so the next 2-3 quarters do not look kind to earnings/growth.

 Is the MFI Model Bust? We believe Not — All may not be lost for the MFIs. Our
recent field trip suggests – a) Strong underlying business economics (and
demand) and b) Large distribution reach, which others have found hard to
replicate. We believe these could lead to MFIs modifying business models to focus
more on: a) Asset-light lending (tie-ups with banks?), b) Distribution of varied
financial (and non-financial products). We believe SKS is relatively better
positioned than peers due to a) Higher capital and b) Geographically more diverse
loan book, but the benefits will likely accrue only after the pain has been digested.

 Clearer picture to emerge by end FY11, would avoid till then — We believe a
clearer picture on regulations (and government priorities) is likely to emerge by
end FY11. Given likely near-term pain, we would like to avoid the stock for now.

SKS: Downgrade to Sell

We are downgrading SKS to a Sell (3M) with Rs605 target price. We also reduce our
earnings by 41-52% over FY11-13E, factoring in lower NIMs, slower loan growth and
higher credit costs. While we do not make a bearish case on the fundamentals of the
business itself, we believe the improvements will likely be gradual and will require
modifications of SKS’ business model as well adjustments by its large customer base.
The stock has corrected sharply over the last couple of months, but we believe that the
current regulatory changes will have a meaningful impact on its operations (earnings,
growth, asset quality and funding) even if there is a relatively quick resolution. In the case
of further delays, the impact could be higher. In sum, we see risks to the downside as
greater than possible medium-term upsides to the stock.

Stabilizing, but Regulatory Overhang Remains
Microfinance operations in AP are in the process of bootstrapping and, after a
period of a near halt of operations, are slowly limping back to some semblance
of normalcy. We believe however that the process will be slow, and will take at
least 2-3 quarters even in the best case (assuming the regulatory impasse is
resolved quickly). However, the broader picture remains blurred for
microfinance operations in India (especially in AP which is the largest exposure)
as regulatory pressures are likely to remain in place. We expect this scenario to
be clearer by end FY11 post the RBI’s Malegam committee report on MFIs and
the government’s focus on financial inclusion initiatives.

We believe that SKS is better positioned relative to its peers given: a) Recent
capital raising, which reduces its leverage (total assets/equity) to 3.2x (Sep 10)
and b) a geographically more diverse loan portfolio, with Andhra Pradesh
contributing only 28% of its loan book (Sep 10). This will likely be relatively
beneficial for SKS when the dust settles on the sector, but the benefits will likely
show through gradually and there will be some more pain to endure before that.
We are reducing our target price on SKS to Rs605 per share, based on our
EVA model (and benchmarked off 2x FY12E P/BV), factoring in a) a 41-52%
reduction in earnings, b) lower growth prospects over the medium term (30-
40% loan growth medium term) and c) higher asset quality risks over the next
2-3 quarters.

Takeaways from the Field Trip
We recently went on a field trip near Hyderabad with SKS to meet end
customers and understand the on-the-ground impact of the AP regulations on
the operations and collections of SKS. While our sample set was indeed very
small to be representative of its entire customer base, we believe there were a
few takeaways which could be generalized.

 Operations have started to normalize gradually. SKS has started to hold
Centre meetings in more areas and more frequently (while a weekly meeting
is still not being held) and disruptions have largely ceased.
 Attendance at the centre meetings is however still relatively low (around 60%
on average).
 No fresh lending is being done by most MFIs in AP (SKS included).
Customers seemed to be aware that this is largely due to the AP Ordinance.
 Most customers we met believed that a Monthly repayment model would not
be conducive for them and they would prefer to continue with a Weekly
repayment model.
 Customers said that availability of timely credit is more important than
interest rates charged (while welcoming any reduction in interest rates).
 There is a demand for insurance products (SKS has currently stopped
collections for insurance products) and customers wanted to continue with it.

Impact of the AP Microfinance Bill
The AP Microfinance Bill was ordinanced on Oct 15, 2010 and has recently
been tabled in the state assembly. We believe that, if enacted, there will be
several implications for the MFI sector, including:
 Net Interest Margins: While the ordinance does not talk about interest rates
as such and has capped repayments at 100% of principal, some MFIs (most
notably SKS) have come forward and reduced lending rates. We believe this
is likely to be followed by others as well over time. Moreover, access to bank
funding for MFIs has become significantly tighter and costlier as well. This is
likely to impact NIMs negatively for the sector. We believe loan spreads for
the sector can fall by at least 2-3% (from over 15% earlier) over the medium
term due to the combination of lower lending yields and higher funding costs.
 Loan Growth: Given the uncertainty over the MFI Bill, most MFIs have
currently stopped any fresh disbursements in AP and have certainly slowed
down (if not stopped completely) even in states outside of AP. The current
MFI Bill talks about reducing the extent of overleveraging by borrowers and
intends to limit an individual to loans from 1SHG + 1MFI only. This will likely
be a further dampener to growth in the state as currently there are multiple
MFIs lending to individual borrowers. We believe loan growth for the sector is
likely to reduce sharply from the over 100% growth rates seen over the last
couple of years.
 Asset Quality: Collections for MFIs in AP have come down sharply over the
last couple of months due to a) inability to contact borrowers, pending
registration with AP government, b) inability to hold centre meetings due to
disruptions/protests, c) changing of collection frequency to monthly from
weekly and d) borrower reluctance to repay MFIs. We believe that unless
there is a quick resolution to the current situation and there are orderly
meetings held by MFIs, the losses are likely to increase significantly.
Moreover, the shift in the repayment model to monthly (from weekly) entails a
significantly higher repayment burden (amount per installment) on the
borrowers and some of them may be unable to make this transition smoothly
(as most of them are daily earners with relatively minimal savings propensity).

 Access to Funding: Most banks have become increasingly risk averse while
lending to the MFI segment and prefer to wait till there is more clarity on the
operations of the companies. Meanwhile, most banks have reduced lending
to the sector significantly, overall exposure to the MFI sector remains at
around 0.35% of the loans for the banking industry. We believe that access to
funding (both debt and equity) will remain tight for the sector and will also cost
significantly more than what has been available in the recent past.

Is the MFI Model Bust?
We believe not. While we do expect a period of painful adjustment over the
medium term, we believe the MFI model has a couple of key fundamental
strengths: a) the underlying business economics of the MFIs is sound (there is
real demand and availability of credit seems to be more important that interest
rates per se) and b) they have built a strong last mile distribution network in
difficult to reach segments of the country, which other institutions have found
quite difficult to replicate.
We believe these will lead to the basic MFI model remaining as functioning over
the medium term – but there could be some modifications along the way to suit
the revised regulatory regime and a more for-profit model. These changes
could be in the form of  a) a move towards a more asset-light model of
financing – there could be potential tie-ups with banks (which still have priority
sector requirements) and b) utilizing the distribution network more effectively by
distribution of more financial and non-financial products, and we believe microinsurance will likely be one of the key products to be so distributed over the
medium term.

Banks’ exposures to MFIs
Indian banks have both direct and indirect exposures to microfinance; the direct
exposure is typically in the form of exposure to Self-Help Groups (SHGs), while
the indirect exposure is through lending to various MFIs.
The total exposure of the banking sector to microfinance is around Rs302bn (as
at March 2010), 1.05% of total loans of which around 0.7% is through SHG and
0.35% though MFIs. We believe that, currently, the sector is undergoing
significant stress and some of this loan book is likely to come under stress over
the next 2-3 quarters. While the larger MFIs are likely better placed (due to a
diversified loan book and higher capital comfort), the smaller ones will likely be
more vulnerable. While it is still too early to assess the actual impact of
microfinance exposures on banks’ NPLs and earnings, we do present below a
sensitivity analysis for the same.

SKS Microfinance
We value SKS at Rs605 per share, based on CIRA's EVA model, which
captures the long-term value of the business, and is a standard valuation
measure for the CIRA India Banking coverage. Our EVA model assumes: a)
risk-free rate of 8.0% in-line with the current 10yr G-Sec interest rates; b)
longer-term loan loss provisions of 225bps given its inherently higher asset risk
segment; c) loan spreads of 900bps, which is significantly higher than the
banking sector given its high yielding asset profile; and d) long-term fee income
growth of 12%.
We also benchmark our fair value for SKS based on a 2.0x 1Yr Fwd P/BV,
translating to Rs603 per share. We believe SKS is fairly valued at the lower end
of well-run private sector banks (on P/BV basis) due to its: a) Sharply reduced
growth outlook (relative to its own recent history), b) Reduction in return profile
and c) Increased asset quality concerns especially in Andhra Pradesh. We
prefer the EVA model for our target price calculation as we believe it reflects a
dynamic valuation approach.

We rate SKS shares as Medium Risk even as our quantitative risk–rating
system, which tracks 260-day historical share price volatility, suggests High
Risk. We believe SKS’ more geographically diversified lending portfolio, leading
market position and low leverage levels moderate its risk profile. Key upside
risks that could cause the stock to trade above our target price include: a)
Stronger-than-expected loan growth, b) Reversal to a low interest rate/ easy
liquidity environment, c) Continued robust asset quality over the medium term.

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